Bitcoin, Blockchain and Self-Enforcing Contracts

Bitcoin became the first decentralised cryptocurrency (a type of digital and virtual currency) following the release of a paper hypothesising the currency in late 2008 by the pseudonymous Nobel prize nominee Satoshi Nakamoto. Simply put, it is a digital ledger listing accounts and balances — however, unlike a bank, a copy of this ledger is maintained on every computer in the Bitcoin network. Government agencies are have expressed concern about the widespread use of cryptocurrencies as instruments for money laundering. Cryptocurrencies’ decentralisation, supported by a network of computers relying on cryptography and other techniques, means that they are very difficult to control through suitable laws and other preventative measures.

Figure 1: The changing mediums of exchange — is Bitcoin coming next?

To send your money over to a friend with Bitcoin, you broadcast the amount of money that you’d like to transfer — exactly like usual. Each computer in the Bitcoin network adds your transaction to their copy of the ledger securely, making sure that your balance decreases, and your friend’s increases by the same amount. The network maintains the ledger similar to how a bank does, but the fact that the ledger is maintained by a group rather than a single entity changes things dramatically. Many industry experts refer to cryptocurrencies as the next medium of exchange, as highlighted in Figure 1.

Like any tangible currency, numbers stored in the digital ledger only have value we are willing to use the currency as a medium of exchange. However, there are two key differences between Bitcoin and tangible (fiat) currencies; (a) in Bitcoin, all transactions are visible (but anonymised) (b) in Bitcoin, a user works with anonymous strangers — the system is designed so that no trust is needed. People are excited by Bitcoin because the technology that powers it has uses far beyond the currency. This technology is called the Blockchain.

One of the biggest issues cryptocurrencies face is that people don’t understand them very well. Explanations are either too complex for the average person or made too simplistic with important details missing. Reading through original Bitcoin paper is a good place to start because that is where the proof of Blockchain security was first explained. However, the paper is difficult to understand without a friendly introduction. This blog aims to be a helpful introduction to similar higher-level Bitcoin literature. Figure 2 explains the basics behind Bitcoin and how it can be used for basic payments. Blockchain technology was born out of a security flaw in this type of transaction.

Figure 2: Bitcoin Basics: How it Works

Imagine this: Bob broadcasts a transaction sending money to Alice to pay for his lunch, and then sends broadcasts another transaction sending the same amount of money back to himself, referencing the same Bitcoin to send in both transactions. Some nodes in the network will receive the second double-spending broadcast before the original one to Alice, realise that the input is being reused and both transactions will be rendered invalid. There is no way to prove which transaction came first — and Alice will remain unpaid.

This problem gave rise to the Blockchain, a data structure that allows the system to time-order the transactions by grouping them into blocks and linking them together in the order of their creation. Any computer in the network can suggest what the next block in the chain should be by collecting a set of unconfirmed transactions into a block and broadcasting it to the rest of the network as a suggestion. A ‘Proof of Work’ problem acts as a the mathematical race that mitigates simultaneous block creation.

Figure 3: Blockchain Use Cases: Comprehensive Analysis & Startups Involved

One of the main applications of the Blockchain (highlighted in Figure 3) is that of the Smart Contract — a computer program that can automatically execute the terms of a contract without a third party. Smart contract technology can now be built on top of Bitcoin, a computer program itself, allowing the two to work together seamlessly.

These contracts are set to change the function of professional services firms because they can replace common financial transactions and legal procedures. Imagine you want to bet 1 BTC for Usain Bolt to win the 100m sprint at the next Olympic Games; your friend bets the same amount that he will not win. Each Bitcoin is placed into a neutral account that the smart contract controls. When the race finishes, the contract itself can verify the winner via the BBC and the contract would automatically transfer the money to the corresponding winner of the bet. Smart contracts can be coded to reflect any kind of data-driven business logic: from actions as simple as online payments to the more complex document notarisation and futures exchange.

Figure 4: A Beginner’s Guide to Ethereum

I am drawn to the fact that cryptocurrencies that will undoubtedly be used everywhere in the near future, but without any knowledge of its foundation. Satoshi Nakamoto has now been nominated for a Nobel prize, yet they remain anonymous.

Amongst the hype that there is around Bitcoin, few understand the technology that makes it safe to use — the Blockchain. There is another shift that is now taking place, fuelled by Ethereum, the decentralised platform that runs smart contracts (Figure 4) — many cryptocurrency leaders are now realising that as the adoption of the technology becomes more widespread, its inherent flaws in scaling need to be fixed.

Given its pervasiveness in the finance industry, as well as the actuary and legal professions by way of smart contracts, it is very important that the public understands these concepts before these technologies are widely adopted.

Interests in these areas have been raised at our very own networking event Campus Startup where concepts like AI-based business lawyer hirepeter.com and uses of the Proof of Work problem for social good are already in discussion and development.


This article was written by Harry McLaverty, Vice President at WarwickTECH, Warwick University’s fast-growing tech society founded in October 2014 who’s core aim is to build and foster a diverse community of technologists on campus.


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Figure References

Figure 1: The changing mediums of exchange — is Bitcoin coming next? (http://getbitcoinguide.com/how-to-get-bitcoins-for-beginners/)

Figure 2: Bitcoin Basics: How it Works (http://cdn.americanbanker.com/media/ui/how-bit-works-big.jpg)

Figure 3: Blockchain Use Cases: Comprehensive Analysis & Startups Involved (http://letstalkpayments.com/blockchain-use-cases-comprehensive-analysis-startups-invoved/)

Figure 4: A Beginner’s Guide to Ethereum (https://blog.ethereum.org/2015/06/21/ethereum-messaging-masses-including-fathers-via-infographic/)